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Short-term credit has a deep bite. Whether to pay needed household expenses or to satisfy the itch for the latest gadget, obtaining a subprime or payday loan can be risky.
Payday Loans – Debt Trap
The interest rate is steep: Annualized, it can be upwards of 400 percent per year. Yet an even bigger problem is the short payback term, says Professor Robert Mayer of Loyola University of Chicago. “Interest and principal are due in full in two weeks. Many of the cash-strapped, subprime consumers who get these loans don’t have any slack in their household budget to repay these cash advances so quickly. As a result, where the law permits it, most payday loan customers will roll over their debts again and again, paying a new fee every two weeks but not retiring the principal. They become trapped. Some will start borrowing from a second lender to pay back the first. Unless state regulations are stringent, it is perfectly feasible to have not one payday but many payday loans,” he says.
Nationwide, says Prof. Mayer, the average payday loan customer gets eight cash advances per year. “That means this average person is paying very high fees 16 out of 52 weeks in a year. … But this average conceals a lot of variance. Even in states with stringent regulations, a sizable minority of payday loan customers will be indebted the whole year long.”
These customers will pay the fees but not be able to reduce the principal on the loan. “In the olden days,” says Prof. Mayer, “they used to call creditors who vended this kind of product ‘loan sharks.’ But I think a more accurate label is ‘debt trappers.’ Wherever payday lending is legal, debt-trapping has been licensed.”
Illinois offers some protection to payday loan customers. A bill still in committee prohibits second and subsequent loans to a customer “if the total of all payday loan payments coming due within any month … during the term of the loan exceeds the lesser of $1,000 or specified percentages of the consumer’s gross monthly income.”
Near the intersection of Dempster Street and Dodge Avenue are two fast-cash loan stores. A few hundred yards away, within a Dominick’s Food Store, is the sole bank in the area now known as Evanston’s West Village. Peter Braithwaite, alderman of the Second Ward, in which these stores lie, would like to see them both leave town.
Municipalities have very little recourse against payday loan stores, since they are regulated by the state. A city’s best weapon is its zoning code, says Prof. Mayer. Evanston now allows payday loan stores only as a special use in certain business areas, giving City Council discretionary authority over allowing more such stores to be established in Evanston.
Credit Where Credit is Due
The purpose of credit is to provide temporary liquidity – and the emphasis should be on the adjective,” says Richard Romano of Romano Brothers Wealth Management. Prof. Mayer terms credit “deferred payment. … One receives cash or goods now, either to consume or to invest, and repayment is postponed, typically in exchange for a fee. We call that fee interest.”
The increased accessibility of credit has for many people made living solely within one’s paycheck a thing of the past.
“There has been a long-standing slow shift from the philosophy that grew out of the Great Depression in the ’30s, where credit was unacceptable,” says Jay Lytle, one of the directors of First Bank & Trust of Evanston.
“Life seems to go in cycles in the banking industry – a very rapid expansion in 1968 with the multipurpose credit card – opened up credit well beyond department stores and gas stations,” Mr. Lytle adds.
Payday lending came of age two decades later, in the 1980s, says Prof. Mayer, with banking deregulation, growing income inequality, and the decline in personal savings. “Americans save much less than they once did. … The extension of credit is probably one of the factors [attributable to this trend]. People save less now because they don’t have to; they can borrow instead and pay it back later.”
The stream of credit that buoys most commerce can drown someone whose cash flow is continually squeezed because income does not meet needs or wants. Mr. Lytle, Mr. Romano and Prof. Mayer advise caution in deciding when and how much to borrow and say the foundation of these decisions should be building a good credit rating. A good credit rating, essential for obtaining a loan to purchase a home or a car, can be built by paying bills on time. Using a credit card instead of cash for convenience rather than credit, paying off the entire statement each month and paying utility and other bills on time go a long way toward building up good credit, say Mr. Lytle and Mr. Romano. “Savvy consumers should cultivate a high credit score from an early age. The best way to do that is to repay one’s debts on time, every time,” says Prof. Mayer.
With a good credit rating a person can take out a loan for life’s large necessities. “Borrowing now and paying later is often a shrewd choice,” says Prof. Mayer. “Credit makes it possible for people to seize opportunities and to make productive investments or to stimulate demand for goods and services. Without some credit, most people could not afford to get a college degree when they are young or to buy a home or to start a business,” he adds.
“Credit is a valuable mechanism when properly used,” says Mr. Romano. “Businesses need startup expenses, and this is a good use of credit, provided your projections and your ability to pay are good,” he adds.
Prof. Mayer says debt can be considered “enforced savings. … Understood in this way, credit is a beneficial institution. It allows people to spread expenses over time and to make productive investments that can benefit others as well as themselves. The world would be a much poorer place without credit.”
But taking on more debt than one can repay leads to the debt trap. Easy, accessible credit is the bait for those whose needs – or even wants – regularly overtake the spending ability of a paycheck.
The extension of relaxed credit may have been a factor in the blurring of the line between needs and wants.
“Where the process has gotten into trouble is when people have taken on more debt than they could service – when people are out of cash if they want something,” says Mr. Romano. “Unless you can clearly define the mechanism to pay back [a loan], you could be in trouble,” he adds.
“The penetration of credit into the bottom half of the population, which accelerated in the 1980s, may have allowed [that part of the population] to keep up, more or less, with the top half in the race of consumption: smart phones, computers, flat-screen TVs,” says Prof. Mayer.
With the collapse of the credit bubble, however, the divide between the haves and the have-nots may again be seen in differences in consumption and lifestyle, Prof. Mayer says. “That method [credit] of connecting top and bottom may not work any more, with the collapse of the credit bubble. With less credit for the bottom half, differences … between the top and bottom might become more noticeable. Time will tell.”
Next time: Financial Literacy